1. What is the Cost of Common Equity?

The cost of common equity represents the return required by equity investors for investing in a company's common stock. It is a crucial component in capital budgeting and corporate finance decisions, helping determine the minimum return a company must generate to satisfy its shareholders.

2. How Does the CAPM Calculator Work?

The calculator uses the Capital Asset Pricing Model (CAPM) formula:

Where:

• \( K_e \) — Cost of common equity (%)
• \( R_f \) — Risk-free rate (%)
• \( \beta \) — Beta coefficient (unitless)
• \( R_m \) — Expected market return (%)

Explanation: The CAPM model calculates the expected return on equity by adding a risk premium (beta times market risk premium) to the risk-free rate.

3. Importance of Cost of Equity Calculation

Details: Accurate cost of equity calculation is essential for determining a company's weighted average cost of capital (WACC), evaluating investment opportunities, making capital structure decisions, and assessing company valuation.

4. Using the Calculator

Tips: Enter the risk-free rate (typically based on government bonds), the stock's beta coefficient (measure of volatility), and the expected market return. All values must be non-negative percentages except beta which is unitless.

5. Frequently Asked Questions (FAQ)

Q1: What is a typical risk-free rate used in CAPM?
A: Typically, the yield on 10-year government bonds is used as the risk-free rate, as they are considered virtually risk-free investments.

Q2: How is beta coefficient determined?
A: Beta is calculated by regressing a stock's returns against market returns. A beta of 1 indicates the stock moves with the market, below 1 is less volatile, and above 1 is more volatile.

Q3: What are reasonable values for market return?
A: Historical market returns typically range from 7-10% annually, though this varies by market and time period. Long-term historical averages are often used.

Q4: Are there limitations to the CAPM model?
A: Yes, CAPM assumes markets are efficient, investors are rational, and that beta fully captures risk. It may not account for all risk factors that affect stock returns.

Q5: When should CAPM not be used?
A: CAPM may be less reliable for private companies, companies with unusual risk profiles, or in markets with limited historical data. Alternative models like Fama-French may be more appropriate in some cases.